93 Location Independence with Systems Trading with Bill Dreiss of Dreiss Research Corporation - 1of2

Niels

Hi everyone, and welcome to another episode of Top Traders Unplugged. Thank you so very, very much for tuning in today. For those of you who are regular listeners, you know that my goal with the podcast is to share the stories of some of the greatest traders in the world and to ask those questions they don’t usually get asked. To help you get more clarity, confidence and courage to take your own trading or investment career a step further, and today’s episode is no exception.

Today you are listening to episode 93. If this is your first episode that you’ve ever heard, you might want to go back and listen to all the earlier conversations.

Bill

This is Bill Dreiss, President and Founder of Dreiss Research Corporation, and you’re listening to Top Traders Unplugged.

Niels

By the way, if you want to read the full transcript of today’s episode just visit the TOPTRADERSUNPLUGGED.COM website and sign up to receive access to all of them. Now let’s get started with part 1 of my conversation. I hope you will enjoy it.

Bill, thank you so much for being with us today. I really appreciate your time. Now what’s really exciting about our conversation today is that you, in many ways, are very unique in the sense that not many firms, in our business, that have been around for more than 40 years, are still headed up by its founder – not even the firm that I work for, so I just want to say up front to everyone listening in today that it will be worthwhile sticking around and learning from Bill’s wealth of experience. Before we jump into all of the topics we’re going to cover today, I just have this simple question that I try to ask all of my guests in order to appreciate the many different answers that there is to this question. It’s basically, how do you respond when a person you haven’t met before asks you what you do? How do you explain what you do, Bill?

Bill

Well it’s frequently difficult because most people don’t have any reference point. Basically I tell them I’m a commodity trader and then I mention gold, wheat, and copper – things like that. And they say, “Oh yeah.”

Then I probably mention that I trade futures and most people might understand what that is. Perhaps what I do is I say, “Well, it’s something like being a hedge fund manager.” That helps a little bit, but it of course depends on the extent of which people have exposure to these kinds of financial services.

Niels

Sure, absolutely. We’re going to stay with you for a lot longer and talk about your story. As you may know, I have a strong belief that you can’t really understand a trader or a manager and his track record without understanding the background and the story behind it. I’m going to start out by focusing on this today. Tell me about how it all got started for you? Feel free to put some extra color on how you were as a young man growing up, or as a kid – go back as far as you want.

Bill

Well I think my pertinent history is that I graduated from MIT with a degree in electrical engineering and then went on to Harvard Business School where I was attracted to Bayesian Decision Theory, and also just had an interest in operations research. After I left school I went to work for a think tank in California that was doing computer modeling of strategic and tactical warfare, and that introduced me to really state of the art modeling.

We were doing computer modeling mostly, although some of it was being done by hand. This was in the days where we were using the most powerful air force computers, which probably were comparable to today’s pocket calculators. At any rate, we were really operating in state of the art mathematics in many ways, so it was very interesting.

Niels

How did you get into using the air force computers? That sounds a little bit unusual.

Bill

Well, it was because of the type of work… We were working under air force contracts and we were exploring different kinds of tactics in missile firing strategies, or ground wars in Europe and that sort of thing. We were working for… Most of the work was done by young engineers with mathematical backgrounds.

The supervisors were retired air force officers. One of them had done some commodity trading and he interested me in commodities. I became aware of Richard Donchian and what he was doing and also started reading the literature of the day – things like Edwards and MaGee. I started experimenting with the idea of developing systematic trading methods. Out of that came the ideas that I used to develop my first system back in the late ‘70s.

Niels

Sure, so just to place this for the audience; so leaving MIT, we’re back in the ‘60s? Am I right in saying that?

Bill

I graduated from Harvard Business School in 1966 and then went to work. So I went to work for about three years or so in the think tank. Then after leaving there I really focused on developing a trading system and spent several years – two or three years at least, exploring that.

Of course, once I got out away from the think tank work environment I didn’t have access to computers so most of the work I did was by hand. Never the less I understood what it meant to be systematic. I had a big pile of CRB charts that I would go through and try out and try various things. Partly for this reason my focus… And partly from the influence of Edwards and MaGee, my focus was on what would be typically understood as technical analysis: heads and shoulders, and triangles, and trend lines, and so on and so forth.

One thing that I did early on is I went through the various chart patterns that were supposed to be significant and I decided that the only one that really had any usefulness was the trend line, then perhaps support and resistance. All these other patterns were essentially like seeing images in clouds or reading tea leaves and they really had no meaning.

So in terms of designing a system I guess my idea of the thing that was perhaps somewhat unique was that most of the system that I was aware of, or at least methods that I was aware of, were numerically based: things like moving averages. Whereas I was inclined towards trying to systematize certain aspects of technical analysis – like trend lines, and then be able to use trend line breaks as signals.

So I developed a system along those lines and at some point it occurred to me… And again, this sort of happened out of the blue because I wasn’t really aware of anything else going on along these lines. I thought, “Gee, maybe I can actually manage other people’s money and make this into a business.” Of course I was unaware that perhaps other people were doing that at the time. It was certainly a new idea to me and a new idea in, I think at least in the area where I was living, which was the Bay Area.

Niels

Is that where you grew up as well?

Bill

No, no, I grew up in west Texas and Kansas. I went to high school in Kansas. After I got out of school then I had jobs in southern California and then I moved from there to Northern California. I just happened to be there at the time.

Probably the main influence over where I lived and where I’ve lived since is that after I got out of school I learned to surf, and that became somewhat of an addiction, which has stayed with me ever since. One of the things that attracted me, I think, about commodity trading was that it was something I thought that I could do from a lot of different places – anywhere I wanted to live, and I could live near the beach and have a lot of free time to surf.

Having developed a system, I decided it was time to perhaps learn the other side, or learn something more about the industry. So I got a job as a commodity broker with EF Hutton in San Francisco. I raised a few clients and traded my system as a broker for my clients. While I was there I met some sales types, and probably about a year later we left to form a company, Commodity Consultants, to trade managed accounts. They would provide marketing.

Niels

And we’re back in the mid ‘70s now, if I’m right?

Bill

OK, at this point we’re to early ‘75 and the start of 1975. About a year later we split off. We reorganized and I split the trading part off as a separate company, but we continued to work together for the next several years. At one point I probably had, oh I don’t know, 180 clients and probably over 10 million dollars under management, which doesn’t sound like much, but in those days it was big money. Certainly among the traders I was aware of, I was probably the largest for a while.

Niels

How did you… because I think this is important for people to realize, 180 clients, even today that’s a lot, even with all the computer power we have, but back then it must have been an enormous task to handle. How did you go about doing that back then?

Bill

That is what inspired me to get my first computer. I had read the same ad in Popular Mechanics that Bill Gates had read. What he did was he quit school, and what I did is I went to Albuquerque and bought an Altair computer from the first computer store, which was assembled by the wife of the guy who owned the computer store, and brought it back.

I was having, the accounting as you imagine, the accounting – of course this was prior to having 180 clients – the accounting was becoming a nightmare to do by hand so I thought, well, I really need a computer. The idea, in those days, that an individual human being could own a computer was a miracle, so I bought an Altair and brought it back. I had to bring the hard disc back on my lap because they were so sensitive to getting out of alignment. I had a Teletype 33 as my keyboard printer, and essentially put the programmers I had working with me – a couple of friends of mine who were also MIT graduates – so we programmed the accounting into my computer. I had an accounting system that was more accurate than the brokerage firms that we were dealing with, which is not saying much I suppose. That was my first impetus to being probably one of the earliest adopters of personal computers back in 1976.

We subsequently put my system on the computer, but as you said, the primary motivation, because of the number of clients I had, was to get the accounting automated.

Niels

Sure, then you ran that for a period of time, but as far as I recall from preparing for today, there was a time where you stopped actually managing outside money, if I’m right?

Bill

Well, I ran, as I say, I was quite successful for a while in terms of my returns and raising money and then I went through a period where I pretty much flattened out for a year or two. Since I was essentially using third party marketing, and they were representing other managers, and of course, my clientele tended to shift to other traders.

At some point my business ran down. It’s not as if I really blew up or anything, it’s just that my clients drifted away and I have to admit that I grew a bit disappointed in my system and at that point I pretty much closed my clients accounts and just continued to trade from my own account, partly so I could experiment with various other approaches. I also got interested in software development, so I shifted my business focus to writing custom software and doing computer consulting at that time. Of course if you remember back in the early ‘80s was the heyday where personal computers were really starting to take off, so that in itself was an exciting time just to be involved in the computer industry.

Niels: Absolutely, then in 1991 you decide to set up your current company. What made you refocus, so to speak, on the trading and the research and how far were you really in terms of your research at that time compared to what we’re going to talk about latter of how the strategy operates today?

Bill

Well, as I say, even though I moved out of managing other money, I continued to research and to do research and to think about various ways of approaching the markets. One thing that caught my attention and the attention of a colleague of mine that I’d been working with, was the work of Benoit Mandelbrot – fractal geometry. There was a book that came out in the early ‘80s I think, The Fractal Geometry of Nature.

It was apparent from reading this that this had application to modeling the markets. In fact, Mandelbrot’s first paper that he published was on the cotton market and that introduced the world that was in compilation by Paul Cootner called The Random Character of Stock Market Prices. That really was the beginning of Mandelbrot’s career in fractal geometry and of course, sometime later that we picked up on this.

We could see from this that it was applicable. Of course another approach that was also popular at the time was the Elliott Wave. Robert Prechter had really developed a reputation by his work in that regard. One of the things that we were looking at, because the Elliott Wave is obviously a fractal kind of approach where you have patterns within patterns, within patterns, we thought, “Well, I wonder if it would be possible to automate the Elliott Wave?”

Well the short answer is no, and the reason is simply that if you have the kind of restrictive conditions that are invoked by the Elliott Wave the market won’t cooperate. So you’ve got to do a lot of… you’ve got to essentially shoehorn the data into the model.

What I found was that it was better to devise a model that fit the data. What came out of that was what we designated as the Fractal Wave Algorithm. The Fractal Wave Algorithm is essentially a method of deconstructing prices into a series of fractal patterns. Once again it’s self-similar across KO, meaning that you have a short term pattern that can be combined into a longer term pattern, which can be combined into a longer term pattern, etc. All of which have the same shape.

In fact, the underlying pattern is what we call a zigzag, which is merely the price goes up, the price goes down, and then the price goes up again; or there’s one in the opposite direction of course. You can then put these zigzags together.

So if you have an up zigzag, a down zigzag, followed by an up zigzag, then you have a larger scale zigzag. Then you can take that zigzag and have an up, down, and up, and you have a larger scale. That forms a fractal structure.

What is all this good for? Essentially what I decided to use it for was to be able to mechanically specify turning points in the price. The easiest way to think about this is the Dow Theory which has short term waves imbedded in medium term, which are imbedded in longer term waves.

So if you pick a particular level of the pattern of zigzags, you can use those points, that is you can use the lows of those zigzags to draw a trend line through. Or if the trend is going down, you can use the highs to draw a trend line through. So this takes us back to the standard Edwards and MaGee type of approach. This is essentially what we used as the basis of my trading system – The Fractal Wave System, which I use to trade.

So once this system had been designed, I thought, “Well, OK, this is pretty interesting so it’s time to get back into the business.” I think through this time I had always maintained my registration as a CTA, so it was easy to get back into business.

So I formed a partnership with, again some marketing types, and off we went. I think the reason I found my system or the new approach attractive was twofold: one had to do with a theoretical basis, meaning that there’d been, ever since the ‘60s when there’d been this explosion of interest in the financial world, especially the academic world – the fish and market hypothesis, and the idea that the markets were random walks and so on and so forth. There’d been an ongoing controversy, shall we say, between the academics and the practitioners about whether it was possible to actually make money in the markets by really any methodology. Of course the academics, with the exception of Mandelbrot, took the positon that the markets were random and so it was futile to try to figure out a system.

The traders, or people out in the financial world were on the other side of that and they generally, their argument was anecdotal, they could say, “Well, what about Warren Buffet? Or what about various people who had demonstrated success?” But of course that argument was a little bit suspect because if you have enough people out there doing something, some people are going to be successful just by chance. Somebody is going to win the lottery regardless of whether it’s chance. Nobody expects that to be due to skill on the part of the…

What I was interested in was something that was, shall we say, a little bit more convincing. That’s what, again, what Mandelbrot was providing, because Mandelbrot said that if you analyze the markets – and of course by that time other people had taken up this approach also – you find that the markets, in fact, are not random in the sense that was normally discussed, but actually had biases. In fact, the markets exhibited persistence, which meant that generally if you had trends on almost any timescale, these trends would tend to persist a bit more than you would expect over a pure random walk.

So if you could demonstrate that persistence, which is possible using Mandelbrot’s mathematics, or using the using the fractal mathematics, or power law analysis, then you had, in a sense, a theoretical basis, a scientific basis for saying that it was a least possible to make money in the markets by some sort of a trend following method. Then, of course, the next step was to use a similar kind of rational to actually design a trading system.

So that’s essentially what I did. A lot of the work that I was doing was not just a matter of designing a trading system. It was based upon analysis of the markets of quite a few… generally the commodity markets, that indicated that these markets, in fact, exhibited persistence and that there was a reasonable expectation that trading systems would work.

Of course this applies not just to my particular approach, it applies to any kind of trading approach. In other words, the fact that fundamental traders or somebody like Warren Buffet or George Soros or whatever, the fact that they make money in the markets, as far as I’m concerned is, for the same reason that I can make money in the markets. That is that these markets exhibit persistence. The fact that their analysis is different than mine is, I think, of secondary importance.

The same goes with trading systems. So much of the focus when people are evaluating trading systems is on the particular methodology that’s being used. In my opinion, the primary reason that say, systems traders in commodities are able to make money in the markets is that the market provides those opportunities. It’s the market that provides the returns more than the particular methodology that’s imposed.

Of course you can see that if you compare performance, particularly among CTAs is that sometimes the markets are easy to trade and other times they aren’t. Of course that gets you into the whole idea of every few years you hear that trend following is dead. Well, trend following is not dead, it’s just sleeping. You go in and out of these phases an it has more to do with the nature of the markets than it does with the vagaries of any particular system.

Behind all this, all that I’ve discussed, has to do with technical trading and designing systems and of course what I do is purely mechanical. I run my program every day and I do what the program says. I don’t second guess it, I don’t omit trades or anything of that nature. Obviously the system is adjusted on a periodic basis just to keep it up to date, but other than that, my system has been virtually unchanged for the last 25 years.

At any rate, my view on this is that underneath the statistics or the mathematics that describe markets are fundamentals. That is, I’m a technical trader that believes in fundamentals, so I believe that markets – certainly commodity markets – are move by supply and demand. I believe that financial markets are moved by economic forces, most of which are fairly long term. I would call these business cycle moves.

So this has influenced me, along with just my research, to trade very long term. I trade off weekly charts, and I’m probably one of the longer term traders that are out there. Of course, in one sense, that originally had to do with the fact that if you trade longer term, you trade less frequently and that lowers your transaction cost, which I think is still important even though commissions are so low these days you still have to deal with slippage every time you trade. The less frequently you trade, the less of a load there is in that regard.

I think more importantly I discovered that, for the most part, if I traded longer term I essentially got the same… Let’s suppose I had the typical trend might be several months. Now a shorter term trader might take three or four trades out of that trend. It seemed to me it’s better just to take the whole thing.

So you can step back a little bit and trade less frequently and still get the same benefit as if you were trading in and out more frequently. In fact, you might even get more benefit because of eliminating a lot of the slippage. To some extent this exposes you to a bit more drawdown exposure. This is because if you’re trading longer term then you’re stops are further back, so that means that the markets, individually, can move much more dramatically against you before you get out.

I find that if you’re trading a diversified portfolio, then that tends to mitigate it to some extent. Also, of course, depending on the behavior of the markets, very frequently, where other shorter term traders would be getting out and back in on a fluctuation in the prices, I’ll ride through it so that I end up coming out at a better place after a pull back. Like a say, these things are all tradeoffs in these various approaches. I’m satisfied, certainly over time, that my risk control and my drawdowns and all that are certainly no worse than those that are experienced by people who trade a somewhat shorter term.

Niels

So in terms just to round this off in a timeframe, I want to go back and ask you about some of the things that you mentioned just now. In terms of timeframe you still run your systems only once a week, or are they run more than once a week, but just using a weekly bar for that matter?

Bill

I update the system, that is I recalculate once a week. I have to obviously follow the markets on a daily basis because I get fills and I have to put in… If I go into a trade, I need to put in the stop loss and so on and so forth. So I need to maintain it on a daily basis, but no, I only calculate orders once a week.

Niels

Now I want to go back a little bit. There was a lot of information coming about Dow Theory and Elliott Wave and the fractals and how these things play together. Also the fact that, as you rightly said in the beginning, you started out by looking at traditional technique and analysis, but also realized that there’s a lot of subjectivity in that and that’s not necessarily a good thing. So automation became very important for you. Back in the ‘90s I was working in London, and I was running a CTA there that was a pattern recognition and it sounds, without me being an expert in any of the things that you mentioned, it sounds somewhat similar where we had identified a number of patterns that repeat themselves and so on and so forth.

What we couldn’t do in the ‘90s was we couldn’t automate that. Because it was based on some level of having a computer to recognize this. How and when did you manage to automate this? When you mentioned Elliott Wave, I think most people are familiar with, or a lot of people are familiar with that and they understand the 1, 2, 3, 4 , 5 and A, B, C down, and they understand that, But when you explain it, at least the way I understand, is that the six axis can form almost like an unlimited amount of different patterns, so if you can touch upon the way you manage to automate that, but also the quantity of different patterns that you’re looking for if that can be drilled down a bit.

Bill

Well, I normally don’t think of what I do as pattern recognition in the conventional sense. I’m not looking for heads and shoulders, or triangles, or wedges, or that sort of thing. As I said before, I decided early on that those are meaningless. So whether or not I could automate that was irrelevant. So what I did is I… like I say, early on I decided that the only patterns that really had any usefulness at all were trend lines, and support and resistance, which are pretty fundamental.

Later on, when I got into fractal geometry and again thinking in terms of the Elliott Wave and the Dow Theory, we identified the zigzag as the fundamental pattern. Once again, you can say, “Well, that’s pattern recognition.” But it’s hard to imagine a more fundamental pattern than that. If you understand what I’m saying. If you look for something more fundamental than a zigzag you’ve got nothing basically.

Niels

You’ve got an up move or a down move.

Bill

That’s pretty much ground zero in terms of designing. Of course, that’s essentially the kernel or the basic pattern underlying the Elliott Wave. That is if you have a five wave, is a zigzag with up, down, up, down, up, right? And a three wave is the basic zigzag of up, down up.

Now the problem with the Elliott Wave, as I said before, was that it restricted you to fives and threes, generally speaking. If you actually worked… that’s a top down judgement. In other words, that’s a fundamental belief, or fundamental structure of the Elliott Wave is to impose that pattern onto the prices.

If you go from the bottom up, where you say OK we’re going to build this up from zigzags and the zigzags are determined from the price. In other words, the price goes up and then the price goes down and the price goes up, right? You’re not imposing that pattern, that’s a pattern that the prices, the market itself is putting out there, then you can obviously have more than, shall we say, five waves. Things can go up and down and up and down and up and down and it can do this as long as it wants and then it can turn around and do the same sort of thing.

So if you use the bottom up approach like we did, then you can’t insist that the waves be five or three. They could be seven, or nine, or obviously not less than three. But never the less, you can use those in the way that I described to construct a series of turning points at various fractal levels and then, as I say, those turning points can be used.

Again, this is different than the Elliott Wave. In the Elliott Wave you’re essentially using these patterns to predict. Anybody who has traded for any length of time realizes that prediction is impossible. Prediction is hard, especially about the future. So what we were using this for, what I use this for is not to predict, it’s merely to provide a mechanical, objective means of identifying turning points which can then be used to draw trend lines.

Of course this goes back to Edwards and MaGee and the problem with something like standard technical analysis is a technician draws a trend line, but three technicians will draw the trend line in three different places. But the Fractal Wave Algorithm draws that trend line in one place. It will draw it in the same place every time. In other words, that’s the whole idea.

So what my system does is it combines, it takes technical methodology, shall we say or ideas that are traditionally based upon subjective judgements and it implements those in such a way that they’re mechanical or automatic and that, I think, is the advantage. So of course the system itself will do things that to a technician would look irrational, at times, but that’s the tradeoff. On the other hand, what the system does is the system provides discipline and it eliminates the possibility of second guessing, which of course is the bane of the technical analyst.

So the advantage of this, to get back… And this of course goes back to the original days when I got into this business, was that…  And I think anyone who is one of the early systems traders would confirm this, is that when we first got started in technical trading, it was like shooting fish in a barrel because there were very few people doing it. Most of the people trading commodities were small investors or people trading by the seat of their pants.

So you had an incredible… Just the discipline that a system provided was an incredible advantage over most of the traders that were out there. So it turned out to be very easy. Almost any system would work. Donchian’s moving average crossover – I knew a guy who had a system based upon a moving average turning. The moving average turned up, he bought, and it would turn down, he sold. So almost any system worked better than what most people were doing which was taking the advice of their broker, or just trading on their gut feel. Now-a-days things are much different. Those people are gone. The industry is dominated by people… by systems traders and so it’s a much different environment. By the same token, so one would think that this would all get arbitraged out over time. That is if you had nothing left but the…

Niels

The big trend followers.

Bill

The big trend followers, and certainly trend following dominates the CTA space, you’d think they’d all just be cannibalizing themselves. I think this gets back to what I was saying, that I’m a technical trader that believes in fundamentals. So there’s a world out there that can’t be controlled or that’s beyond the reach of market psychology or market methodology and I think that world is subject to forces – generally longer term forces – that are pretty much universal and timeless.

Niels

Human behavior, yeah.

Bill

That go back in history as far as you want to go and that will go into the future as far.

Niels

You know, I agree with all that, Bill, and it’s interesting because there’s obviously still so much resistance, it’s fair to say, by a lot of people, certainly on the investor side, to embrace this and you always have to justify why trend following works. Even if it has a year or two of under average performance then it’s their case for why it has stopped working and it’s never going to work again. So certain things don’t change.

I want to go back also to another point which I think differentiates you a lot compared to the managers that we see out there. Maybe you can explain more that where I’m going with this is that I know that you, or at least part of your system is not looking at parameters, meaning you’re not trying to optimize a certain parameter set while, if you use moving averages, or price breakout, whatever it might be, clearly a big part of the research is really identifying the right parameter sets to use. Explain to me about that and why you’ve chosen this way of looking at it.

Bill

Well, of course the idea of data fitting has been the nemesis of anyone who’s tried to design systems. So one of the attractions to the fractal approach was that you’re dealing again with very fundamental patterns, but you’re dealing with patterns as opposed to numbers. You’re dealing with pictures instead of the numerical approach. So in the first place, if you adjust the algorithm the way I’ve described it, is not a matter of optimizing on any kind of numerical parameters. It’s a matter of setting up a certain structure and then, in a sense, graphically utilizing that structure to translate that into patterns.

Now there’s certainly data fitting in the sense that you’re fitting what patterns that you think are significant versus those that you don’t. You’ve obviously got to have some choice there. For instance, trading weekly charts versus daily charts, that’s obviously a parameter that you’ve selected. But these might be numerical parameters but they’ve been selected on a qualitative criterion. They haven’t been selected because I went through and tried all the different possibilities and picked out the best one. It was a much broader type of judgement that was made.

So the advantage, again is that, in terms of designing a system, you’re not really focusing. You’re coming into it with an analysis that’s based upon, shall we say, qualitative judgements about how the markets work and so on and so forth. Then that’s implemented more or less directly without having to go through a lot of optimization, testing, and so on and so forth. Obviously you’re going to backtest your methodology and if it doesn’t look like it works you’re not going to use it. So right there you are data fitting.

Nobody uses a system that doesn’t test out. You certainly can’t avoid that kind of parameterization completely, but you can certainly keep it to a minimum and also avoid being deluded by it. I think the worst thing that comes from parameterization is you tend to think you’ve got something that’s a lot more, say magical, than is actually the case.

Now I do have some parameters in my system, but once again, these are not optimized parameters, they’re parameters that have fallen out of the patterns that form. So for instance, if you think about these zigzags, if you have a certain zigzag pattern, and then you take a larger scale zigzag, where you’ve got a zigzag made of those zigzags. You typically are going to have… The duration of those zigzags is going to about three times the duration of the shorter zigzag, OK. Then the next level up it’s going to be about three times that. So you actually have some parameters that tend to fall out of your patterns, but they’re not parameters that you just went and tried everything. They’re parameters that actually are a result of applying your algorithm.

Again, I don’t vary that, so for instance I might use a pattern – a 27-week pattern. I use 27 weeks everywhere. I don’t use 26, and 28, you know, that sort of thing. Because, once again, the parameters have come out of the patterns, it’s not something that’s been independently derived or optimized.

Niels

Sure. Of course we’re going to talk more about this latter on, but when it comes to risk management, though, parameters are difficult not to apply: how much should I risk, etc. etc. Obviously people usually come to these conclusions based on research and so on and so forth. How do you, just sort of broadly, frame that in terms of just the parameter side of things, not exactly the risk management, we’ll talk about that a little bit latter?

Bill

Yeah, well but risk management is pretty much common sense. Everybody’s risk management is the same. Risk management is driven by the realities of the business. To some extent it’s a matter of choice. In other worlds, I’ve decided to operate in a certain, shall we say level of leverage. You find that the level I operate in is probably towards the high end among CTAs. If you get much higher than that then you are out of business.

Most CTAs, as they get big, they tend to cut their leverage. So the typical CTA is probably about half of what I use. But again, that to me is pretty standard. In other words, I can just glance at somebody’s performance record or whatever – just basic stats, and I know what region of risk or of exposure that they’re operating in.

If you look at those people, the people who are established and have been around for a while, they’re all in the same ballpark. You look at me versus Dunn or various other people with similar shall we say standard deviations – monthly standard deviations or similar drawdowns, or whatever, we’re all doing the same thing. We’ve got about the same margin to equity.

So I think that, to some extent, money management’s another issue. Once your system generates a series of trades, which may or may not be correlated. Typically, you’re going to have about 40% winners and 60% losers and on and on. That’s why I say that different people have different systems and, certainly from a marketing point of view, it’s nice to say, “Talk about how special your system is.” But you’re really pretty much driven by what the markets are doing and what they offer you in terms of possibilities.

Someone who… A well designed system is going to do a reasonably good job of capturing what the market offers, but it’s more of either you’ve got one or you don’t, it’s not a matter that there’s a lot of distinction in terms of what the outcome is. Once again, the outcome is pretty much driven by the level of the amount of leverage that you take. If you normalize to that leverage, then anybody who’s been around for a long time is going to have pretty much the same performance.

Niels

I want to jump to the next topic very shortly. I just have some maybe philosophical questions I wanted to just to ask you. When you look back at your career, which you may do from time to time, do you think back at this as some kind of quest you’ve been on to perfect how to exploit the fractal nature of markets, or is there something else that drives you if I can phrase it that way?

Bill

Well, everybody’s got different motivations. I suppose when I first started out in this business, one of the things that attracted me to it was the idea that I could make a living, live where I wanted to, and surf a lot. I’ve really, more or less, surfing has been the sort of primary determinant of where I’ve lived in my life. So I saw this as a way of capitalizing on my, shall we say my education and my experience in order to have a lot of leisure time. So I wasn’t thinking in terms of, “Boy, how much money can I make.” I was thinking more in terms of how much…

Niels

How you can get on the waves, yeah, sure.

Bill

For most of my career that’s been my primary focus. Now the problem is it’s hard to… If you’re in a business that’s about money, it’s hard to ignore it. If you’re a social worker or something, you can sort of ignore money and get the satisfaction that comes from doing your work, but if you’re in the money business, to some extent, money is how you keep score.

I think if I look back, essentially my judgement is I’m probably a pretty good trader, but I’m a lousy business man. I haven’t really done a very good job of utilizing whatever skills I had in terms of developing a business. As I say, part of it’s just been neglect, and part of it’s been I’ve relied largely on third party marketing which tends to be fickle.

So I’ve had ups and downs. I’ve had periods where I’ve raised a lot of money and then it tends to… My performance tappers off, then the money goes away. That’s just the nature of the business. If I had it to do over again, shall we say from a business view, I would have taken much more responsibility for my own marketing, because I think that’s how other firms of the same generation, like Dunn or John Henry or people like that, I think their success is primarily due to the fact that they’ve been successful in marketing and they’ve taken responsibility for that as opposed to trying to farm it out on third party marketers.

Niels

Sure, that’s true. Now we’re going to leave the background, but there’s one question I simply can’t avoid having to ask you because it is so clear from how you explain it and that is the importance of not serving the markets but serving the waves and the ocean, and that is why is that so important to you and how did that all get started, because it seems to be something that has stayed with you through and through?

Bill

Anybody who has surfed realizes how addictive it can be. I’m not the only one who’s found that to be compelling. Of course it’s not just surfing, there are ski bums and golfers – there’s people who do all sorts of activities and not necessarily sports. But surfing becomes something more than a sport. It just is really an engaging endeavor that’s man against nature and a lot of other aspects to it.

I’ve spent years surfing surf breaks in Northern California where there was nobody on the beach, nobody in the water, so there are a lot of really attractive aspects of it. Plus, you get to… it inspires you to travel around to various places. It inspired me to live in Western Australia for 13 years, which is where I got started with my Fractal Wave System.

It’s a very engaging sport. I might also say that even from the very beginning I had absolutely no desire to live in Chicago or New York and to engage and to become a pit trader or any of that sort of thing. To me that was just nuts. I justify that partially by saying that I wanted to be as far from the markets as possible, so I wasn’t influenced by that kind of group think. The main reason for being a systems trader is to insulate you from your own bad psychology shall we say. If you’re surrounded by people who are surrounded by an environment of opinions on markets, then it’s hard to resist that.

In order to insulate me from that I’ve done two things: one, I’m a systems trader; and two, I’ve stayed away from those places. The difficulty with that, again, looking at it from a business point of view, if you want to raise money, the place to be is Chicago or New York, not Western Australia, right?

Niels

Absolutely. As I’m sure you can tell by now, my knowledge of surfing is very, very limited but since we all meet a few sharks in our business I also have to ask you as a final question, whether you, in your surfing every met any sharks in the water?

Bill

I’ve never actually seen a shark in the water, except when I’m scuba diving, or that sort of thing, but as a surfer. When I lived in San Francisco, that area is called the red triangle between Bodega Bay, the Farallons and Monterey, it’s probably the “sharkiest” place in the world. Where I lived in Australia is pretty “sharky” also. So they’re around, but you’re either on the bus or you’re off the bus.

It’s surprising, not only are they around, but they’re surprisingly abundant, and surprisingly close. I think what you learn, one of the things that, I don’t know, you can just be eternally thankful for is that we’re not on their menu. It’s the same with killer whales. Gee, if killer whales wanted to eat you, you’d be in bad trouble, but for some reason they just don’t have any desire to do that. So that’s one of the blessings of being a surfer.

Niels

Well let’s hope it stays like that. Now, today of course, we’re going to talk more about the Global Diversifier Program which is the name of your strategy, and also, it’s interesting that I guess it’s this year that you will be celebrating your 25-year anniversary, if my math is correct. So I want to ask you about knowing that what you wanted to achieve was also the location and dependence and so on and so forth, the fact that you’ve successfully run this now for 25 years. You’ve automated it to a large extent. You’re clearly not doing everything yourself, so what kind of people have you surrounded yourself with in terms of organization in order to do this on a day to day basis?

Bill

Well, from a traditional point of view, I pretty much did it myself, in terms of the trading, until about five years ago or so. Now I’ve got someone who does most of the trading. I’ve got what might be called a virtual office. I don’t have an actual office space, but I work from home and my trader works out of Albuquerque, and I have programmer that’s worked with me a long time that’s also remote. In addition to that, my trading system is setup on a remote server. This is, of course, primarily for security reasons and also the thing has multiple backups and mirrored disks and all this. We just log in using remote desktop to run the system.

The system itself, once it was programmed back in 1990, it’s been virtually unchanged. So it hasn’t required… that is there hasn’t been any kind of maintenance that’s done, it’s most done, it’s mostly by adjusting the portfolios and various options, shall we say, that can be set, flags that can be set. The program itself is pretty stable. The same is true with, probably about 15 years ago I had a program written to do my back office, to automatically read brokerage statements and compare that with my records and do that matching that goes on. So the end result of that is that it takes very little time to run the system and do the back office and the whole thing – maybe a half-an-hour a day, typically, and a couple of hours on the weekend. It can be done by anybody who is competent and diligent and doesn’t require a lot of technical skills. It just involves discipline and persistence.

Niels

So clearly having done it in a certain way of running your business for a long period of time, even though there’s been some changes five years ago, the other impression that I got was that you do want to grow the business, from here. Do you think that in doing so, do you think that requires some changes on your part? Do you think that investors now-a-days require a certain setup? You alluded to it in terms of location, but I’m also thinking now organization, infrastructure. You’ve been regulated by the authorities since the day that they got founded many, many years ago. Everybody from the outside can see that you know how to run a business, but still, do you think that it requires some changes on your side to attract more assets?

Bill

Well, that’s a good question. On the one hand, I certainly have people that open accounts with me and are… Most of my clients, currently and in the recent past, have been sophisticated investors who understand the business. They don’t seem to have any concerns about the way my operation is run. I’ve certainly got a lot of excess capacity in the sense that I could run a much larger AUM with my present structure without really changing anything significantly. Obviously beyond that, beyond maybe 30 million or so, I might have to start beefing up and maybe even get an office. Everything would pretty much run the same.

As far as my software goes, it’s got huge unused capacity. That is, I could trade much larger volumes and handle much larger volumes through the back office with existing software, so I’m certainly not at capacity limited, but do I think the limitations have to do with marketing. I think as time goes by people have become, I shouldn’t say people, I should say probably more institutions shall we say, have become more…

Niels

Tick box oriented.

Bill

Yeah, that’s right, that’s a good point. Again, it can be justified. Everyone’s got somebody to answer to, right? So the fact that I don’t have a formal office and that I don’t have a lot of employees, and I don’t have a compliance officer and all that sort of thing.

Niels

A lot of these things, of course, can be outsourced. They can be virtual, but they could also be outsourced. There is one question I…

Bill

I outsource my performance calculations and that level of accounting, which is highly technical. That also provides a certain amount of credibility in terms of my track record. In other words, I have NAV doing that, so it’s not like people might suspect that I’m fudging my performance.

Niels

There’s one question though, Bill, that I have to ask and obviously being a little bit frank about it, but as you’ve explained, people would have guessed now that you’re not in the youngest part of the CTA space…

Ending

Ready to learn more about the world’s top traders? Go to TOPTRADERSUNPLUGGED.COM and sign up to receive the full transcripts of the first 10 episodes of the show and visit the show notes where you can find useful links to other amazing resources. Thanks for listening and we’ll see you on the next episode of Top Traders Unplugged.